Stocks and Bonds Go Down Together

by J. Orlin Grabbe

Like Jack and Jill going down the hill, stocks and
bonds go down together. This is surprising only to
people incapable of comprehending the most elementary
principles of finance--their understanding polluted,
perhaps, by having watched too much CNBC, or by having
taken a course in macroeconomics.

Restated, when the stock market collapses,
interest rates go up. At this very moment there is a
worldwide crisis in bond markets around the world.
Why? Because stock markets have been crashing, and
interest rates have been going up. Yet many stare at
this phenomenon blankly, uncomprehendingly, and then
turn their attention back to this hour's financial
guest guru on TV, who is distinguished from last hour's
financial guest guru only by the color of his tie: "If
there is to be stock market weakness, you should think
of moving part of your portfolio into bonds."

And the suckers just keep phoning in. Get out of
the bad rainbow stock stew, they are told. Get into
the good rainbow bond stew. That way free lunches and
free bubble-up will continue for everyone forever.

Let's take a very simple example. A software
company which has some existing assets. For
simplicity, let's get rid of future earnings and all
those complicating factors.

The company has $150 of pre-sold software. It has
already produced the software. It has contracts saying
it will be paid $150 for it. That's the company's
assets.

The company financed itself by issuing $100 worth
of bonds. It pays no interest on these bonds. Rather,
the bond principal will be returned to bondholders when
payments for the pre-sold software come in. The
bondholders thus have a claim on $100 of company
assets.

The company has stockholders. The stockholders
own the company. When the money comes in, the
stockholders will repay the bondholders the $100 they
owe them, and keep the remaining $50 for themselves.
So the stock has a value of $50. Restated, the
stockholders have a call option on the value of the
company's assets.

The stock represents a call option, because as
long as the value of company assets is greater than the
$100 owed to the bondholders, the stockholders will
exercise their call option at its strike price of $100
in order to buy (retain ownership of) the company
assets at that price. The stockholders will do this
because the call is in-the-money. Exercising the call
(i.e. paying off the bondholders) only requires $100,
but the value of the underlying company assets is $150.

So here is the company's balance sheet:

Assets

Liabilities

$150 pre-sold software

$100 in bonds

Equity

$50 value of stock

Bonds are a direct claim on the value of company
assets. Stock is a call option on the value of company
assets. Do you begin to see why bonds and stock values
might decline together, if the value of the company's
assets falls?

Suppose that, because of a declining economy,
people begin to renege on their sales contracts. Sure,
they've agreed to pay for software, but all the lawyers
in hell can't get blood out of a turnip. As a
consequence, the company's management make their best
determination that only $110 of their sales are
collectible.

The stock is now only $10 in the money, and its
value has fallen accordingly. The company's balance
sheet now looks like this:

Assets

Liabilities

$110 collectible sales

$100 in bonds

Equity

$10 value of stock

Meanwhile, the bondholders, who have been monitoring
the company because they have a stake in it, say to
themselves: "Hmm. The company theoretically still has
enough collectibles to pay back the $100. But suppose
management is wrong? Let's get out of these bonds, and
dump them on some other suckers."

But news of the company's problems has leaked out.
So when the bondholders go to sell their bonds in the
secondary market, the purchasers say to themselves:
"The economy is deteriorating. Maybe the amount of
collectible sales is even worse than everyone thinks.
We had better allow for more margin of error. We will
only pay $90 for the bonds."

So, if the bond trade takes place, it takes place
at $90. Since the bonds have a face value of $100, the
implied interest rate on the bonds (ignoring any
adjustment for time factors) is:

$100/$90 - 1 = .1111 or 11.11%.

Interest rates have gone from zero to 11.11%, while the
stock value has declined from $50 to $10 (that is, to
20 percent of its previous value).

We will call the bonds issued by this company,
Software bonds.

"Yes," you say. "All this may be true of Software
bonds. But what about Mafia bonds?"

Mafia Bonds

The Mafia provides protection services. The
Mafia's goons roam throughout the neighborhood
demanding "protection payments" from each of the area's
residents. If some individual declines to pay, the
Mafia's goons beat him about the head and shoulders
with sticks, and also on the shins and kneecaps, until
he voluntarily agrees to pay the required amount.
Otherwise, the goons simply carry off the individual's
assets back to Mafia headquarters. In either case, the
Mafia gets the requested payment.

The Mafia goons who collect protection payments
are known as the Icon Restoration Society (IRS). They
view their work in religious terms.

Since nearly all goons are employed by the Mafia,
the Mafia has little work to do with respect to its
protective services. And the Mafia likes to make its
bondholders happy. Consequently, Mafia bonds offer a
healthy 5% interest. Here is the Mafia's balance
sheet:

"Yes, things are getting worse for everyone. The
Mafia goons may have to apply a few more strokes with
their sticks. But, we know from history, they always
collect their payments! Mafia bonds are sound
investments.

"That's why we have now made it mandatory that all
retirement funds be invested in Mafia bonds. We want
to protect retired people. You can always count on
Mafia bonds, even when times are bad!"

Some people, hearing these words, rush out to dump
their Software bonds and buy Mafia bonds. This further
depresses the price of Software bonds in the secondary
market, increasing their interest yield to 13%, while
driving up the price of Mafia bonds, decreasing their
interest yield from 5% to 4%.

"Aha," you say. "See. Because of the
deteriorating economy, stocks have gone down, while
interest rates have fallen from 5% to 4%. See, you
were wrong. And I will live and retire to drink the
free bubble-up and eat the free rainbow stew after
all."

Meanwhile, however, over at the University,
trouble is brewing because of the Heretic, Dr.
Painexpose.

The Mafia Theory of Economics

Dr. Painexpose is angry. "The system is a
gigantic fraud," he says. "The Mafia doesn't produce
anything. Yet people rush to buy Mafia bonds when the
economy deteriorates. This pulls capital out of
productive enterprises like Software, and Machines, and
Wheat-Growing, while increasing the resources available
to the despicable Mafia, which produces nothing."

"Don't listen to him. He is a heretic," the other
professors say. "He doesn't teach the Mafia Theory of
Economics like we have always taught it, and like we
bequeathed to him."

"He is just an anti-Mafia rabble-rouser," some
say. "He is in the secret employ of the Software
companies," others assert.

The chancellor of the University receives a phone
call: "We regret to say that there will be a hold-up
in this year's Mafia grant for the promotion of the
teaching of the True and Verifiable Principles of Bond
Economics. We hope to have this straightened out as
soon as possible."

But Dr. Painexpose is undeterred. "Making
retirement funds buy Mafia bonds is a joke. By
diverting capital into unproductive goon activities,
you are assuring that the economy of the future will be
in even worse shape than it is now. So you are not
increasing the economic security of retirees. You are
in fact decreasing their security. The date at which
we run out of free bubble-up and free rainbow stew is
now closer than ever!"

"All the Mafia goons in hell," Dr. Painexpose
further declares, "can't get blood from a turnip."

"Dr. Painexpose is a fear-monger," the newspapers
say. "Your bubble-up is secure," declares Stanley
Ichthyophagist, Chairman of the Department of Mafia
Economics. "By our careful calculations, and
subtranscendental logarithms, we have determined that
there will be free bubble-up forever. The thirsty can
relax."

"Dr. Painexpose hates old people and wants to
steal their retirement funds," declares Mike
McCorleone, Mafia spokesman. "But what we wonder is
what defect of Dr. Painexpose's psychology would lead
him to make such statements, to have such extreme views
of the world. Was it something in his childhood? We
fervently hope that Dr. Painexpose is not depressed or
suicidal."

Soon thereafter, Dr. Painexpose is found crucified
upside down, hanging from a rock face in New York's
Central Park. The Park Police quickly rule the death a
suicide.

"He obviously wanted to be a martyr," a Park
Police spokesperson explained.

Meanwhile, the economy continues to deteriorate.
Collections by the IRS become ever more difficult and
forcible asset extractions ever more public. The
newspapers interview one man who was beaten to a bloody
pulp outside his front door.

"Well, I couldn't help reflecting, as the IRS
jerked my last piece of furniture out of my hands,
stepping on my wrist and smashing a rod across my
kidneys--even in my pain, I couldn't help thinking: At
least my retirement is secure. After all, it's all
invested in Mafia bonds."

Data

The New York Times, the newspaper of record, which
prints all the news that's fit to print, declared on
September 17:

"Toting up the dollars lost by investors in
bonds in August is difficult because of the
market's opaqueness: $48 billion was lost in
emerging market debt that was denominated in
dollars, $14.6 billion disappeared from
portfolios of convertible bonds, another $15
billion was likely lost in junk bonds and
$1.67 billion disappeared during the month
from an index of real estate investment
trusts that invest in mortgage securities.
That's about $80 billion lost." (September
17, 1998)

Let's see. Bonds went down in August. Stocks must
have gone up, right? One or the other, else the
rainbow stew isn't secure. Maybe it's time to get out
of bonds?

"Dealers at major Wall Street brokerage firms
are no longer bidding for bonds from their
customers; they will only take an order if
they know they have another customer
interested in owning the bonds. And since
few investors are interested in adding to
their bond positions until they see the
market stabilize, most sell orders don't get
executed."

If you want to know the "cause" of all this stock,
bond, and economic trouble, I would direct you to my
article "The Collapse of the New World Order," coming
next month in
Liberty
magazine.